What Is APY? What It Means And How To Calculate It

Financial terms and acronyms can be off-putting and intimidating for some. The term “APY” can fly by during banking and investment ads on television and you might not know what it is. APY is short for “annual percentage yield,” and it’s less complicated to understand than you might think.

What Is Annual Percentage Yield (APY)?

Annual percentage yield (APY) is the yearly rate of return on deposits in high-yield savings accounts, certificates of deposit (CDs), money market accounts and other types of savings accounts. As you shop for these kinds of short-term savings accounts at different banks, they are all required by law to announce the APY of their investment products.

APY And Compound Interest

Besides the interest rate your investment earns, you should also pay attention to the role of compound interest in measuring annualized percentage yield.

Compound interest is calculated at a specific frequency, such as daily or monthly, then added back to the principal (your initial investment) so the next interest calculation includes the now-larger principal. This results in exponential growth of the investment balance. Thus, the more frequently interest is returned to your account — or, compounded — the faster your account will grow.

How Is APY Different From APR?

In addition to APY, you might also frequently confront the acronym APR as you shop for different financial products. They are quite different. As we’ve established, APY refers to the percentage of interest you can earn from a savings account, certificate of deposit (CD), money market account, or even checking account, taking into account compound interest.

Conversely, APR stands for annual percentage rate, which refers to the actual amount of interest you pay to borrow money. Typically, this percentage is used when banks describe credit cards, mortgages, personal loans, and other debt products. Although APR doesn't include compound interest, it does include any additional fees you may have to pay.

How To Calculate APY

If you think you were pretty good at high school algebra, and you’re considering investing $10,000 in a CD, you can calculate the worth of your investment over a period of time using a simple (ahem) formula:

A = P * (1 + r/n)^nt

It’s less complicated when you realize that this equation determines that the (A) amount of compound interest that you'll earn depends on a number of factors, including the (P) principal amount of your initial investment and annual interest (r) rate. The (n) number of times per year the interest is compounded is another factor in the rate of return, as is (t) the number of years you hold the investment.

1. Understand Your Variables

Depending on your strategy and the institution you’re investing with, these variables will all be different, but let’s look at each of them individually before we mock up an example:

• A = amount: This is the answer to the equation figuring how much interest you’ll earn depending on the terms of the account.
• P = principal: This is the total amount of your initial investment on day 1.
• r = stated annual interest rate: This figure, expressed as a decimal, is the amount the bank will pay you for having your funds invested in their CD or savings account for one year. So a 5% annual interest rate is calculated as .05.
• n = number of compounding periods: This is the number of times that interest is compounded per year. So, if interest compounds annually, this number is 1, and if it occurs monthly this number is 12, etc.
• t = time: This is the number of years you hold the account.

2. Input Your Variables

Let’s create an example to see how this equation works. Say you invest $10,000 in a CD at an annual interest rate of 3%, compounded monthly, and you want to know how much the account will be worth in 10 years. Plugging in the variables as described above, with A being the answer we seek, the other factors in the calculation look like this:

• P = 10,000
• r = 0.03 (decimal)
• n = 12
• t = 10

Plugging those figures into the formula, we can calculate as follows:

A = $10,000 × (1 + 0.03 / 12)^(12 × 10) = $13,493.54

3. Interpret Your APY

In trying to determine which institution or type of account is best for your money to earn interest and grow, the higher the rate or interest being offered is an obvious plus, but equally important is the amount of principal at the start as well as the compounding frequency.

An account that compounds interest daily, for example, will grow faster than one that compounds monthly. This is because each time the interest compounds and adds to the principal amount, the principal is higher the next time and therefore the return is a little higher, and so on with each compounding.

Another way to simplify the way compounding interest and a better rate can grow your wealth is the Rule of 72. This rule says that the annual interest rate of an investment multiplied by the number of the years it takes for the investment to double equals 72. So if you have an investment returning 8% per year, it will take around 9 years to double your money (because 8 times 9 equals 72). If you only earn 6%, it will take 12 years for your investment to double (6 times 12 equals 72).

FAQs About APY

Here are some of the most common questions to consider when discussing APY.

What’s a good APY?

In Q2 of 2024, according to the Federal Deposit Insurance Corporation (FDIC), the top high-yield savings accounts were offering rates from 4.5% to as high as 5.35% APY. In contrast, the average U.S. savings account rate is just 0.46%.

Which is better – a lower or higher APY?

An account with a higher APY will earn more than one with a lower APY. An account with a higher principal amount also earns more, as does one that compounds more frequently.

How does compound frequency impact APY?

The more frequently the interest is compounded in a checking, savings or high-yield savings account, the faster the account will grow. This is because an account’s principal increases with each compounding, and thus the increase is more each time.

Is APY variable or fixed?

The APY on checking, savings, or certificate of deposit holdings will vary across products and may have a variable or fixed rate.

The Bottom Line

The best high-yield savings accounts, money markets and CDs accrue interest at a higher rate and compound daily. Since these investments grow exponentially, they return more when the initial investment is higher and remains invested for a longer period of time. So get help saving and growing wealth for your future with the Rocket Money^SM app.